What Do JP Morgan, KPCB and the Yankees Have in Common?

On several occasions this week, I’ve had folks ask me: What’s with the crazy investments and insane valuations? Are we in a bubble? What does all this mean? Even if not in those precise words, it has been the theme of most conversations. So I thought, why not try to deconstruct what’s going on?

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This being the early days of spring training, I have baseball on my mind. And it’s no surprise that’s the analogy I use to explain what’s going on around Silicon Valley.

A few years ago, when the New York Yankees re-signed Alex Rodriguez for an ungodly $275 million, the question that popped in my mind was: Why? Don’t get me wrong; I’m a Yankees fan — just not a fan of A-Rod, especially not at the price the Yankees are paying for him.

That wasn’t the first time the Yankees overpaid for a free agent player; pitcher C.C. Sabathia and first baseman Mark Teixeira have all benefited from the Steinbrenner family’s largesse. Some call them franchise players (though a true Yankee fan accords that status to Derek Jeter and Mariano Rivera): players that help define a team. The Yankees don’t mind spending on them because they believe they’re good for business. Why?

They help put a lot of fans in the seats, which means the team makes a ton of money from full stadiums.

They also help them win championships often enough, which helps them sell more tickets and make more money.

Actually, the Yankees don’t have a choice. They have to keep spending insane amounts of money on free agents because they have to keep generating revenues to — guess what? — pay for all these expensive players. It’s like having the tiger by the tail. Let it go, and be eaten.

Of course, we’re beginning to see similar behavior in Silicon Valley, where investors are overpaying for a handful of some of the hot Internet companies.

Kleiner Perkins Caufield & Byers (KPCB) snapped up $38 million in Facebook stock in the secondary market at a valuation exceeding $52 billion. In January 2011, Facebook raised $1.5 billion from Goldman Sachs and DST Global at a $50 billion valuation.

KPCB, using its Digital Growth Fund, has invested $253 million in Groupon, Twitter and Facebook.

Zynga is reportedly raising $250 million in new funding at a valuation of between $7 billion and $9 billion.

Groupon raised $950 million in funding in December 2010.

Andreessen Horowitz snapped up $80 million in Twitter stock. Twitter is said to be valued at around $10 billion.

Many of these investors can rationalize that these are natural monopolies, and thus worth any price. But crazy, insane valuations aside, many folks are realizing they have no choice but to go after these big players, because they are “franchise” deals.

Since these are consumer-centric companies, they will continue to get a lot of attention and will remain the cynosure of the media attention. For an investor like KPCB, which had being edged out of Silicon Valley’s front row, this is a good way to get back to its winning ways. For new firms like Andreessen Horowitz, big investments in Groupon, Twitter, Facebook, Zynga and Skype are a good way to supplement their investments in some younger, lesser-known companies.

Yesterday, Bobbie Johnson, our European correspondent, asked the question, Can We Avoid Another Internet Bubble? The answer to his question is, “No.” Why? Because we’re already in one, and we just didn’t notice it. It has been nearly 20 months, during which we have seen a sustained (and somewhat unnatural) interest in seed-stage companies. The arrival of new angels meant that on almost any decent-sounding deal, someone was willing to overpay. Lately, Sand Hill Road firms have been throwing money at early-stage deals, at higher and higher valuations.

At the same time, we now have Wall Street banks like J.P. Morgan showing up with hundreds of millions of dollars for investing in social media companies. The arrival of banks like J.P. Morgan and Goldman Sachs means we’re already way into a frothy environment. Of course, these banks are going to chase some of the bigger names, which will further inflate their valuations. J.P. Morgan is bringing its sack-full of dollars, only to make sure Goldman Sachs and Morgan Stanley don’t run away with all the tech-IPOs. It needs franchise names on its roster, and it’s willing to spend like only a Wall Street banker can. In other words, we have massive frothiness on two extremes of the market: the early stage and late stage.

What does it mean for startups? It depends on what kind of startup you are. If you’re getting out of the gate just about now, it’s a great time to raise angel funding. As I wrote earlier this week, it’s fairly easy to grab seed-stage funding, thanks to the largesse of rapidly multiplying angel investors.

However, the bad news is that because there are many more startups, there’s a talent crunch, and no matter how much money you might have raised, finding the right people in this frothy environment is a difficult task. This means your costs of doing business are going to be higher, which in turn means your startup has a much shorter runway. Get it off the ground into the sky fast, or else crash into the weeds.

If you’re growing, the subsequent rounds of funding are going to follow. (As I wrote earlier, this was the main reason Foursquare, Tumblr, and RadiumOne have managed to line up their coffers.) Somewhere along the way, you’re going to become a franchise player and get gobs of money at an ungodly valuation. Like Quora, which is being valued at $300 million!

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The flaw with the previous bubble was that companies that had no fundamentals, no business, and even many with barely any user scale, were raising money, and going public. Everyone was betting on potential. Once that potential never showed up, everything collapsed. Today, companies like Groupon and Facebook and Zynga have shown that they can generate cash and can generate it at a serious scale. There are of course a lot of risks in front of them, but they’ve proven that they’ve built a viable business that even if they don’t grow, at least have a sustainable business based on getting money from real world people (not just a VC pyramid scheme). Now companies like Quora and Path and Twitter who haven’t yet built a real revenue generating business and are getting high valuations, well, I think there’s where you get into bubble territory. It’s a mistake to lump them all into one. Luckily, the universe of people who would be affected by Twitter, Quora and Path imploding (not saying they will, but if) are just VCs and LPs, which will have trickle affect, and will affect the funding environment, but I don’t think will have a huge affect on the macro economy. So in my opinion there’s definitely bubbly behavior, but high valuations != bubbly, though it often does :)

When you say “It has been nearly 20 months, during which we have seen a sustained (and somewhat unnatural) interest in seed-stage companies” are you referring to the examples you provided above (facebook, groupon, zynga, twitter)? If so please help me understand your definition of seed stage.

I am pretty clear in outlining that there is a sustained interest on the top end of the market — that is where the folks from jp Morgan are rushing to and at the bottom end of the market, where there is a massive seed stage activity. I think in between those extremes is relative quiet for now, barring a handful of deals which are reserved for companies with big traction! Hope that explains things more clearly.